Make Way for Variable Pay

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Merit-based salary raises are by far the most frequently used incentive pay program. Unfortunately, they do a poor job of motivating performance, explained John A. Rubino, president of Pound Ridge, N.Y.-based Rubino Consulting Services, during his presentation at the 2012 SHRM Annual Conference and Exposition in Atlanta.

If he had his way, “merit-based salary increases would be abolished. Not only are they not motivational, they are
de-motivational to employees,” he argued. “We have to introduce rewards plans that actually help our managers do their jobs,” which is to motivate employees.

“The foundation for all of the rewards strategies we put forth should be to attract and retain the best and the brightest,” Rubino noted. “We need to spend more time on retaining and engaging those who are truly adding value.”

Where’s the ‘Merit’?

A big problem with annual merit raises is that they are viewed as an entitlement—everyone expects to get something. In fact, “at least 99 percent of employees get some increase in their pay every year” under merit-based programs. Those increases, once given, never go away—they compound exponentially, rewarding employees for past contributions for as long as they remain at the company. This is why “your mediocre employees—those who are comfortable with a small but guaranteed salary increase every year—love merit-based pay.”

Another negative outcome is the “zero-sum game ‘kabuki’ dance” that merit-based programs force managers to perform. “The more you give to one employee, the less you can give to another,” Rubino noted. Given the likelihood of working with today’s pay increase budgets of just 3 percent to 4 percent, “How motivated is a top performer going to be with a 4 percent raise, pretax, divided into 26 installments?” he asked.

In short, merit-based pay doesn’t reward merit—“it’s essentially paying for the job; employee performance is an afterthought,” despite all the time and effort managers are required to put into ratings, rankings and performance evaluations.

Moving to Variable Pay

A better way to motivate employees and reward top performers is to shift to variable pay rewards—lump-sum bonuses for goal achievement. “Globally, companies are moving in this direction, and if your company isn’t, eventually it will be,” Rubino predicted.

To make an incentive plan work, there must be a direct line of sight between employee performance and tangible rewards. While “organizationwide profit-sharing programs can create a nice esprit de corps,” they tend not to be effective motivators beyond the executive tier because “it’s unlikely lower-level workers will see a direct line between their work and corporate profitability.”

Instead, variable pay should focus on a mix of qualitative and quantitative incentives tied to individual and team performance, and these incentives should be aligned closely with the corporate culture. Rubino recommended quarterly payouts that are close in time to the behavior that’s being rewarded rather than year-end bonuses.

“Make variable rewards substantial—at least 5 percent of base pay—or don’t give anything until a larger reward is warranted,” Rubino advised. A bonus that is 1 percent of pay isn’t motivational and may have the opposite effect.

Program transparency and effective employee communications are keys to the success of a variable pay program, he emphasized.

Another tip: Over three to five years, slow down or eliminate merit-based raises. Replace them with lump-sum performance-based bonuses with market adjustments to base pay as warranted. Over that period, a variable rewards program can become self-funding as a result of increased performance metrics. “If designed properly, payouts to employees will yield slices from an expanding financial pie,” Rubino explained.

That boost in productivity allows top performers to earn substantial rewards, providing incentives that truly motivate employees—and freeing managers from the need to play the zero-sum game.

Members may download one copy of our sample forms and templates for your personal use within your organization. Please note that all such forms and policies should be reviewed by your legal counsel for compliance with applicable law, and should be modified to suit your organization’s culture, industry, and practices. Neither members nor non-members may reproduce such samples in any other way (e.g., to republish in a book or use for a commercial purpose) without SHRM’s permission. To request permission for specific items, click on the “reuse permissions” button on the page where you find the item.